Tuesday, April 21, 2009
3:52 PM

The Commercial Real Estate Time Bomb has gone off but it has been lost in the euphoria of economic cheerleading and bottom calls based on dubious (at best) earnings reports from banks. Here are a few headline items from the past week or so to consider.

Strip malls, neighborhood centers and regional malls are losing stores at the fastest pace in at least a decade, as a spending slump forces retailers to trim down to stay afloat, according to a real estate industry report.

In just the first quarter of 2009, retail tenants at these centers have vacated 8.7 million square feet of commercial space, according to the latest report from New York-based real estate research firm Reis.

That number exceeds the 8.6 million square feet of retail space that was vacated in all of 2008.

Reis' report shows that store vacancy rates at malls rose 9.5% in the first quarter, outpacing the 8.9% vacancy rate registered in all of 2008, and marking the largest single-quarter jump in vacancies since Reis began publishing quarterly figures in 1999.

Office vacancies in U.S. downtowns increased to 12.5 percent in the first quarter, the highest in three years, as companies cut jobs and new buildings came onto the market, Cushman & Wakefield said.

The national office vacancy rate climbed from 11.2 percent in the fourth quarter and 9.9 percent a year earlier, the New York-based property broker said today in a statement. The amount of newly leased space fell 39 percent from a year earlier to 10.6 million square feet (985,000 square meters), Cushman said.

The first-quarter vacancy rate was the highest since the first three months of 2006, when it was 12.6 percent. “This will be a very difficult year for commercial real estate and for office markets in particular,” said Maria Sicola, executive managing director and head of Americas Research for Cushman & Wakefield, in a telephone interview.

Downtown office vacancies nationwide could come close to 15 percent by the end of this year, approaching the 10-year high of 15.5 percent in 2003, Sicola said. Of the 31 U.S. cities tracked by Cushman, about half already have vacancies of 15 percent or more, company spokesman Dwayne Doherty said.

Manhattan Market

The Midtown South and Downtown sections of Manhattan, the New York City borough that’s biggest office market in the U.S., had the lowest vacancy rates in the first quarter, at 8.1 percent each, according to Cushman. New York overall was third- lowest at 9.6 percent.

Manhattan office-vacancy rates could climb to 12 percent by the end of 2008 as Wall Street companies reduce payrolls, Sicola said. Seattle, the former headquarters of failed thrift Washington Mutual Inc., could see office vacancies approach a record 17 percent, from 12.6 percent in the first quarter, because of job losses and new construction, she said.

General Growth Properties Inc, the second-largest U.S. mall owner, declared bankruptcy on Thursday in the biggest real estate failure in U.S. history.

Ending months of speculation, General Growth, along with 158 of its 200-plus U.S. malls, filed Chapter 11 while it tries to refinance its debts.

But the ongoing global financial crisis made it impossible for General Growth to restructure outside of bankruptcy and could signal further troubles for other financial institutions who are General Growth creditors.

The company expanded steadily through both building and buying malls, the largest acquisition being the 2004 purchase of high-end mall owner Rouse Cos for $14.2 billion. That deal, financed entirely with debt, added 37 valuable U.S. malls to its portfolio, but also added enormously to its debt load.

"There are quite a few companies out there on the buyside who can now buy properties at a deep discount," said Anthony LoPinto, chief executive of real estate executive search firm Equinox Partners. "A lot of fortunes are going to be made out of the Bucksbaums' misfortune."

The Wall Street Journal reported on Thursday that the Federal Reserve was considering offering longer loans to investors in commercial mortgage-backed securities to help jump-start the market for commercial real estate debt.

Its filing in the U.S. Bankruptcy Court in Manhattan makes it one of the largest nonfinancial companies to succumb to the global financial crisis and is the biggest bankruptcy of a U.S. real estate company, according to BankruptcyData.com.

Property prices in China are likely to halve over the next two years, a top government researcher has predicted in a powerful signal that the country’s economic downturn faces further challenges despite recent positive data.

The property market, along with exports, were leading drivers of the booming Chinese economy over the past decade and the slumps in both have taken a heavy toll.

Cao Jianhai, professor at the Chinese Academy of Social Sciences, a leading government think tank, said an apparent rebound in the property market was unsustainable over the medium term and being driven by a flood of liquidity and fraudulent activity rather than real demand.

He told the Financial Times he expected average urban residential property prices to fall by 40 to 50 per cent over the next two years from their levels at the end of 2008.

The Federal Reserve is considering offering longer loans to investors in commercial mortgage-backed securities as part of a plan to help jump-start the market for commercial real estate debt, The Wall Street Journal reported on Thursday.

The Fed since Febuary has been analyzing appropriate terms and conditions for accepting commercial mortgage-backed securities (CMBS) and other mortgage assets as collateral for its Term Asset-Backed Securities Lending Facility (TALF).

But the Fed has shown concern about the quality and term of assets it is taking on its books as it expands the TALF, because it is reluctant to increase its credit risk.

The Journal said the Fed wants to avoid getting locked into long-term obligations because this could make it more difficult for the U.S. central bank to shrink its balance sheet once conditions start to improve.

The Federal Reserve may need to loosen the terms of a new $1 trillion credit initiative aimed at averting a meltdown in commercial mortgage-backed securities, analysts and industry representatives said.

The Fed would prop up the CMBS market by lending against the securities for a five-year term rather than three years, and taking as collateral existing debt rather than just new bonds, they said. The Fed hasn’t said when the program, the Term Asset- Backed Securities Loan Facility, will begin accepting the debt.

“If we don’t get credit flowing again to commercial real estate” through programs like the TALF, “we’ll probably see a very significant increase in defaults on commercial mortgages and further stress on the balance sheets of banks,” said Richard Parkus, an analyst at Deutsche Bank AG in New York.

Atlanta Fed President Dennis Lockhart said today that commercial real estate is “the one domestic factor that keeps me up at night.”

“Many banks are pretty heavily exposed to commercial real estate,” he said in Orlando, Florida.

The Administration is putting high hopes on TALF, especially now that the program will reach as high as $1 trillion (remember when $1 trillion was a lot of money?). It has always seemed to me that TALF would fall short of the mark. The key constraint:

Eligible collateral includes U.S. dollar-denominated cash ABS that are backed by auto loans, credit card loans, student loans, or small business loans that are fully guaranteed by the SBA, and that have a credit rating in the highest investment-grade rating category from two or more nationally recognized statistical rating agencies and do not have a credit rating below the highest investment grade rating category from a major rating agency.

The expansion of TALF to CBMS also requires AAA-ratings. I suspected that limiting the program to investment grade securities would severely curtail the effectiveness of the program for one simple reason - that, relative to expectations of officials, investment grade borrowers are relatively few, and they have maintained that status by not accumulating excessive debt, so already they are not inclined to borrow. The spending bubble was not driven by high grade debt; it was driven by low grade debt disguised as high grade debt. Focusing on high grade debt as the solution will thus prove insufficient to give the economy much traction.

The Federal Reserve reported Wednesday in its so-called Beige Book report of economic activity around the country that "commercial real estate investment activity weakened further" since the last Beige Book report in March.

What's more, there were reports by the Fed's regional banks of "more stringent requirements for commercial real estate loans due to worries of worsening loan quality in the sector."

None of that is surprising. After all, as unemployment rises, it stands to reason that corporate tenants would require less space in shopping centers and office buildings.

"Things are tough in commercial real estate. Values are declining and are likely to continue to do so for awhile," said Kevin Means, managing partner with Alpha Equity Management, a Hartford, Conn.-based money manager.

"But the reason why it won't be as bad as with mortgages is that residential properties are based on many private decisions of personal home owners who are somewhat driven by emotion," Means added. "There are wider swings in value than what you see with the more disciplined activity in the commercial market. So there wasn't as much of a bubble."

In addition, it's worth pointing out that General Growth's bankruptcy does not come out of the blue. The company has been reeling for months and was widely viewed as one of the weaker real estate investment trusts, or REITs.

So even though the General Growth bankruptcy is certainly a bad sign, it may not be the beginning of a massive wave of real estate bankruptcies.

Right Question, Wrong Answer

The sentiment expressed by Paul La Monica at CNN reminds me of the the optimism in residential real estate that lasted for close to a year before the bottom fell out of the market. Now, even though it is widely understood that commercial real estate follows with a lag, optimism reigns supreme. Check out the subtitle: "Even if commercial real estate weakens further, the market probably won't collapse."

I disagree. Many regional banks that avoided the residential debacle, are now left holding the bag on commercial loans.

OK so General Growth Properties was widely expected. General Growth also represented prime properties yet it could barely meet interest payments. What are all the secondary properties and strip malls going to do? When those properties are foreclosed on, where are the buyers going to come from? At what price? And what use is an office that no one wants to rent?

It is harder and harder to rent any space. This is pressuring lease prices yet the debt remains. Debt that cannot be paid back, will by definition be defaulted on.

The idea that "there wasn't as much of a bubble in commercial real estate" is like saying the loss of a hand is not as bad as the loss of an arm. Give it time.

Love Affair With Malls Not Coming Back

America's love affair with the mall is not coming back. Boomers headed into retirement dependent on the real estate bubble have now taken a massive hit on both their houses and their stock portfolios. Neither is coming back soon. Retirement plans will be scaled back to include less travel, fewer toys (boats and cars), and less shopping in general. Moreover, a new wave of frugality has hit the children of boomers.

A quick search for Frugality is all it should take to see that the value of shopping space is declining every single day! And every person becoming more frugal is another person doing less shopping, less buying, and increasingly cost conscious about what they do buy. Margins will collapse. On everything.

And so a tsunami of commercial real estate bankruptcies is just offshore, fueled by a change in consumer attitudes. Few have bothered to take note. Complacency in commercial real estate is not justified nor will it be rewarded.

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